Fiscal Insanity: We Need More Deficit Spending Like A Hole In The Head

Deficit spending is useless for reviving growth in an economy. Public investment crowds out private investment one for one. Final results being mis-allocation of resources and inflation, the poor being the biggest loser.

Deficit spending (DS) by government, within reasonable limits of a few percentage points of GDP, is considered to have a positive influence on the economy. Almost universally, most professional economists, established think-tanks, central bankers, etc, have accepted the above proposition as an axiom. Even within India today (as indeed has always been the case), there does seem to be a growing clamour amongst industrialists and economists to loosen the purse-strings (i.e, accept even greater DS than the proposed 3.5 percent in 2016-17).

The usual suspects justifying DS range from the sophisticated Keynesian multiplier to the lowly “garibi hatao” rationale. The justifications lying in between would include inadequate private investment, boosting demand/inflation, building infrastructure, floods, wars, famines, poverty, income inequality and reasons one can keep adding. DS has indeed been seen as the panacea for all problems facing all governments with ideologies ranging from the Marxist to the liberal to the conservative. Even Keynes wouldn’t have imagined the range of applications for his thesis and this is eerily reminiscent of the usage of Beenie by the retards in “Patch Adams”.

Some notes on the picture  before proceeding:

It was originally made for Helicopter Ben (the previous Fed Chairman Ben Bernanke) and I have changed the photo to replace it with Jaitley.

One could have used the photo of any Indian FM and it would be as much applicable – just that Jaitley unfortunately happens to be at the seat right now. I should also add that some economists like Subramanian Swamy and Chief Economic Advisor Arvind Subramanian would have clamoured for 12 slices.

Why DS doesn’t make sense?

At any given point in time, the capital stock (money, labour, plant and equipment) in a country is fixed. Let’s say that India can execute 100 projects with the capital stock this year without altering the constraints of the regulatory systems. Can we just make the RBI print up a few pieces of paper and execute an additional 10 projects? That’s what the proponents of deficit spending would have us believe.

It all again goes back to William Hazlitt’s “the seen and the unseen”. What we can visibly see is the additional 10 new projects authorised and funded by the government. What is not seen are the 10 or more projects that get stalled or delayed in the private sector due to inflation (by definition, creation of additional money is inflation) resulting in cost overruns and higher interest rates.

So if we get to execute 100 projects with or without deficit spending, how does it really even matter at all? A very important issue and that’s where the pizza example simplifies the issue a bit too much (I like the picture in spite though).

Capital allocation as well as project execution decisions are best left to the private sector. Not only are the capital returns substantially higher in the private sector, the loss making ideas are weeded out in quick order. In public sector units (Air India, for example), tens of thousands of crore have been sunk into what is even today a negative net worth enterprise. Even when the government hands these projects to private companies in the form of PPP, it is essentially falling into the hands of crony capitalists (public capital and privatised profits).

So DS has two negative economic consequences (apart from the moral issue of taking from the poor and giving it to the rich, which is the eventual result of all inflation) as a result of capital allocation by the government – i.e, inefficient usage of capital and crony capitalism. Countries can ill-afford such extravaganzas during normal times, but even less when economic conditions are terrible. So DS is exactly the wrong medicine for a recession. In fact, quite the opposite should be done and a real economic stimulus would be a dramatic reduction of government expenditure and regulations so as to make available more resources to the private sector for investments.

The above would be considered such an outrageous proposal today that I am sure all sorts of epithets would be used to describe the same – anti-poor, pro-rich, fascist, bourgeois,, take your pick. A good reading material on the above issue, and how such a stimulus really worked, can be understood by a reading of The Forgotten Depression 1921 – The Crash that Cured itself, by Jim Grant.

Does DS ever work for the economy?

Obviously DS is good for the government and crony capitalists. But does it ever deliver for the real economy?

In extreme cases, where DS is accompanied by a fall in money velocity, DS appears to work for the short run. Even in those cases one can argue that money velocity would have fallen even faster in the absence of DS and that would have caused a reduction in interest rates and a fall in project costs. In the best case scenario, we are front-ending or forward pulling projects with the inevitable consequences of lower projects in the years ahead. But even in this scenario, we have the two economic disadvantages specified earlier – decreased capital efficiency and/or rise in crony capitalism.

Given this, how can we justify DS every year, year after year, since independence? Almost all developed nations achieved their prosperity without any kind of DS. In fact, as has been repeatedly pointed out by economists of the Austrian School, the only two conditions to achieve societal prosperity are limited government and sound money. DS is very antithesis of both the conditions. It’s time we dump this insane idea.

Will they do it?

I doubt it. From a deregulation perspective, this Modi-led government is way ahead of the previous Congress government. Absolutely no questions on that front.

But on the fiscal side, this government is probably worse (if you take the cheap oil bonanza into consideration). The finance ministry needs a fresh pair to bring forward path-breaking initiatives and given that nothing much has been done in the two opportunities provided, I think it’s time Modi closed the curtains on the Jaitley-Sinha duo.

Ideally, the incoming FM should slash government expenditure with a chain-saw and balance the books in the true sense of the word in a couple of years. We could really get to double digit growth rates in conjunction with very low inflation under those conditions. But Modi is no Ron Paul and whosoever is occupying the FM chair, he will be no Austrian economist for sure. But the very least they can attempt is to cap government expenditure at last year’s levels and allow growth to bridge the huge hole that DS is causing. The poor and the middle-class deserve something more than the handouts and subsidies given to beggars.